Balancing act: Exploring the relationship between risk and return in mutual funds

relationship between risk and return
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Striking a balance between risk and return is a crucial aspect of investing. Therefore, investors must be aware of the risk-return profiles of various asset classes and investment instruments. This can help build a well-balanced portfolio that seeks to potentially optimise returns and mitigate risks.

In this article, we will examine the relationship between risk and return in mutual funds. We will also look at the types of risks and strategies for balancing risk and return.

  • Table of contents
  1. Risk and return relationship
  2. Risk appetite
  3. Types of investment risks
  4. How to balance risk and return
  5. FAQs

Risk and return relationship

All market-based investments carry risk and returns are not guaranteed. However, the degree of risk and return potential may vary.

Typically, investments that have a higher return potential also entail high risk. Similarly, investments that carry lower risk offer lower return potential.

Therefore, investors should carefully consider their risk tolerance before choosing a particular investment.

Risk appetite

Your risk appetite is the amount of risk you can tolerate. For example, if you can deal with fluctuations in the value of your portfolio and the possibility of loss of capital, you have a high risk tolerance. On the other hand, if you cannot bear the thought of even small potential losses, you have a low risk appetite. Therefore, you must understand your risk tolerance to build a suitable investment plan.

For example, investors with a high risk appetite may be comfortable with avenues such as equity mutual funds. Conservative investors with a low risk appetite may prefer debt mutual funds. Balanced hybrid funds, which comprise both debt and equity, may suit investors who are comfortable with moderate risk.

Types of investment risks

Here are a few of the broad risks associated with equity and debt investments.

  • Systematic risk or market risk: Systematic risk is the risk tied to broader market trends and economic factors. This could include recession, geo-political events, changes in interest rates or other policy decisions, and decreased consumer spending. Systematic risk can lead to market volatility across asset classes.
  • Company-specific risk: Also called unsystematic risk, this is specific to a company or select assets. It could stem from poor management decisions, product failures, legal issues, changes in the competitive landscape, or an unexpected event in a company or sector.
  • Volatility risk: Volatility indicates how much the price of an investment fluctuates in a given period. High volatility can lead to significant price fluctuations, increasing the risk of losses. However, it can also present opportunities for higher returns.
  • Credit risk: Credit risk is the risk of default by the issuer of a security. Bonds and debt funds that invest in them are subject to credit risk. The higher the credit rating of the issuer, the lower the potential for credit risk.
  • Interest rate risk: Changes in interest rates can inversely affect the value of fixed-income securities. When interest rates rise, the value of existing fixed-rate bonds decreases, and vice versa. This risk is particularly relevant for long-term bonds.
  • Liquidity risk: Liquidity risk is the risk of not being able to quickly sell a security when needed and at a fair price.
  • Inflation risk: Investment returns that don't keep pace with inflation can lose their effective value. This is because of the decline in their purchasing power.

How to balance risk and return

Here are some strategies for balancing risk and return in investing:

  • Diversify your portfolio: Diversification helps to spread risk across different asset classes, sectors, and geographies. This strategy helps to manage investment risk by reducing the impact of any single investment on your portfolio. Balancing the equity and debt allocation in one’s portfolio is crucial to navigating market cycles effectively.
  • Review and rebalance: Rebalancing involves adjusting your portfolio periodically to maintain your desired asset allocation. This strategy helps to manage investment risk by keeping your portfolio in line with your risk tolerance and objectives.
  • Invest for the long term: High-risk instruments such as equity are more suitable for long-term investing. This is because a longer investment horizon gives time for the market to recover from any short-term fluctuations.
  • Consult a financial advisor: Seek investment advice to balance the risk and return potential in your portfolio. The advisor will guide you based on your preferences, circumstances, and financial goals.

Conclusion
Understanding what is the relationship between risk and return is a crucial aspect of investing in mutual funds. It helps investors choose the right type of investment avenue based on their risk tolerance levels. It also helps set realistic expectations and plan better. By knowing the types of risk and strategies to mitigate them, investors can make informed financial decisions.

FAQs:

How can I determine my risk tolerance?
Your risk tolerance is based on your personal circumstances, such as income, number of dependents, age, etc., and your emotional response to market fluctuations. Additionally, the investment horizon and goal could also influence your risk-return balance.
You can also use risk tolerance questionnaires or speak to a financial advisor.

What are some common strategies for balancing risk and return?
Portfolio diversification across asset classes, sectors, and geographies can help mitigate risk. Regular portfolio monitoring and review are also important.

Is it possible to have high returns without taking on high risk?
A high return potential is usually associated with a relatively higher level of risk. Investors should strive for a risk-return balance that suits their risk tolerance, circumstances, and objectives.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as an endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purposes only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals, and horizon. This information is subject to change without any prior notice.